ISOs or NQOs?

I still regularly get asked this question: Should I grant NQOs or ISOs?

One thing you have to remember if you are going to grant ISOs is that they are subject to more limitations and restrictions than NQOs, and their tax consequences are more complex and difficult to ascertain than the tax consequences of NQOs. In short, ISOs are more complex than NQOs. Thus, if you want to keep your life simpler, you would just choose to use NQOs so that you don’t have to worry about the varying consequences and limitations of the two different types of worker stock options.

What Are The ISO Tax Benefits?

When Congress put in place Section 422 of the Internal Revenue Code, it was trying to make life easier for workers. The benefits that Congress was trying to put in place were:

No ordinary income tax on exercise; and

Capital gain on ultimate sale of the stock, if the two holding periods were met.

The problems:

The spread on the exercise is an Alternative Minimum Tax Adjustment, that has to be reported to the IRS. The AMT taxes due can be significant. They can in fact be so significant they effectively prohibit exercise because the employee can’t afford the taxes.

The employee has to meet two holding periods to qualify for the benefit. They have to hold the option shares for at least one year after exercise and at least two years after option grant. Most employees exercise in connection with a liquidity event and thus don’t meet the holding period requirements. If you don’t meet the holding period requirements the option is taxed as an NQO.

Summary of Differences

ISOs can only be granted to employees. You can’t grant ISOs to independent contractors or board members who are not employees. What this means is that–if you decide to grant ISOs to your employees, you are almost certainly going to have to also utilize NQOs. One reason I favor using NQOs for all types of awards is because it is simpler–you only have to figure out and explain the tax consequences of one type of award to your workers–not two.

ISOs have two holding periods. Most employees won’t meet these requirements and thus not benefit from the ISO tax benefits.

ISOs have to be priced differently for 10% or greater shareholders.

For 10% or greater shareholders, ISOs can only have a 5 year term. NQOs are typically 10 year duration options.

ISOs give rise to Alternative Minimum Tax consequences. The AMT can be hard to figure out. This additional complexity makes life more difficult for everyone–the company and the employee.

You have to give the employee and the IRS notice of the amount of the spread on the ISO that is subject to AMT, by January 31st of the year following exercise. This creates somewhat of a trap for employees. With an NQO, you have to calculate the tax withholding on exercise. An employee can’t exercise until the company has calculated the withholding tax and made the employee write a check to the company for the employee withholding portion. This avoids a situation where the employee doesn’t understand the tax consequences until the subsequent year. There have been plenty of employees who realized too late they owed too much AMT–and that they couldn’t afford to pay it. This is a result that is usually avoided with NQOs.

There is a $100,000 annual limitation on the amount of ISOs that can become exercisable during any calendar year.

You can’t grant immediately exercsable ISOs without problems.

NQOs give rise to a tax deduction for the company. The spread on an ISO exercise is not deductible by the company. The spread on NQO exercises can add up to very substantial tax savings for companies.

ISOs Still Better for Employees

Having said all of this–ISOs are still more favorable to employees than NQOs. It is still possible for an employee to achieve a better tax result with an ISO than with an NQO. It might be unlikely, but it is possible.

Conclusion

If you really want to give your employees the best they can possibly get–use ISOs. If you want to keep your life simpler, and you understand that for the most part employees are typically not going to benefit from the potential tax benefits of ISOs, use NQOs.

Public Policy Recommendation

Congress ought to repeal the tax on transfers of illiquid stock to workers.

This would allow companies to transfer stock directly to workers without requiring the employee to write a big check to the employer to cover the employee’s share of income and employment tax withholding.

I am not sure of the public policy rationale for making it harder for companies to give workers equity. It doesn’t make sense to me.

State Crowdfunding

State crowdfunding is growing in importance. This is driven in part by the inability of the SEC to finalize the Title III crowdfunding regulations (which the JOBS Act required to be finalized long ago).

Both Washington and Oregon have passed state crowdfunding laws (and many other states have as well).

And you might be wondering how Oregon’s crowdfunding law compares to Washington’s crowdfunding law.

Oregon’s law allows the use of debt. Despite the fact that the Washington crowdfunding statute says that it can be used to raise money through the sale of securities, and the Washington securities act defines debt as a security–final regulations from Washington prohibit the sale of debt (such as convertible debt) in a crowdfunding offering.

What Washington Can Do?

I think Washington should simplify its law. Let’s strike the escrow requirement. Let’s strike the pre-approval requirement. Let’s strike the public disclosure of executive compensation. If there is a concern about potential abuse–let’s reduce the overall amount that can be raised from $1M during any 12-month period to something less.

In any event, it is disappointing we have hit hitches in Washington and our law is not yet being used.

In this article we go into the securities law issues companies have to confront before they issue compensatory equity awards to employees and service providers. Believe it or not, you can’t just issue your employees stock or stock options without first finding and complying with an applicable securities law exemption.

For stock option grants, this can mean filing forms and paying fees in various states in which you have employees. And on each option grant you also have to determine whether you have exceeded mathematical limitations imposed by the federal securities law. It is unfortunate that the law puts limitations on how easily you can share equity with workers. This doesn’t make sense, and Congress and/or the SEC ought to revisit the thinking that went into setting these limitations. Regardless, they exist today, and we have to comply with them.

What is Rule 701?

Rule 701 is the federal securities law exemption for stock options. It contains a number of limitations.For example:

You can only use Rule 701 to grant compensatory equity awards (as an incentive for services).

You can’t rely on Rule 701 to raise capital.

You can only make awards to individuals (no entities).

You are limited in the amount of equity you can grant in any 12-month period to the greater of one of three measures.

Despite compliance with federal law, you must still comply with state law (i.e., there is no federal preemption in this area).

How To Issue Compensatory Equity Awards Such as Options to Workers

I’ve written a blog post titled, Stock Option Grant Checklist, if you are interested in the mechanical steps required to technically and in compliance with law grant stock options.